In: Finance
How are interest rate swaps and currency swaps used by the MNCs for hedging?
Firstly, Swap is nothing but a contract like thing, where two or more parties come together for a common cause and deal with exchange- generally exchange of Financial Instruments.But to clarify it more depthly Swap usually deals with exchange of two or more financial instruments that are of different nature.Here, as the question relates with MNC I would like to link swapping with MNC- okay! A common question often arises why does companies use swaping- here it is!usually from a company's perspective, companys will always desire of showing its debt as at a low level so that it will appear as a prosperous one.Here comes the use of swapping- there are many types of swapping .However, the MNC makes use of two common type of Swaps namely - Interest rate Swaps & Currency swaps.With the use of tese swaps, the companies will reduce the amount needed as debt (it is kinda revising debt condition).
We will see what is interest swap & currency swap in detail:
Interest Swap:-Usually in interest swap the terms of interest will be different .As stated in the begginning swaps generally deals with Financial instruments of different nature- Interest swap deals with different Interest rate (usually Fixed and floating).For example- Two parties A and B are in a contract - A owes to pay a sum to B with an interest.At the beginning , A agrees to pay B in Fixed Interest rate & later B receives it with Floating interest charges .There occurs a interest rate Swap.
Currency Swap:This deals with use of different currency in a agreement. For a say: let us assume A & B are in a contract and A gives loan to B and B returns the Principal along with Interest rate. But he pays it in differennt curreny(Eg :Principal in INR & interest in USD).
Now we do link with the swaps and ow MNC use this in hedging;To begin with we need to know what hedging is!
Hedging is kinda strategy used by the MNC to adjust the probability of loss due to fluctuations(either inflation or deflation) in the price level of the goods.It is used as a method of transferring risk by the MNC's. to be precise, it can be defined as rather than making money or earning , hedging deals with the reduction of possible losses to be incurred.
So , to conclude as Warren Buffett's states he and his company "view them as time bombs, both for the parties that deal in them and the economic system."companies makes use of Interest swaps to make various decision .For example:Consider a company expecting to sell a division in one year and receive a cash windfall it wants to "park" in a good risk-free investment. If the company strongly believes interest rates will drop between now and then, it could purchase (or take a long position on) a Treasury futures contract. The company is effectively locking in the future interest rate.And regarding currency swaps if companies has its branches or offices in Foreign , it will make use of currency swaps to hedge its risks with.however the currency swaps may incur more cost but can reduce the risk of the currency.
Finally , the currency and Interest rate swaps are used by the MNC for the following reasons,
* Makes use of it as a Financial tool to hedge its risk
*It can even help the company by acting as Asset liability management tool.
*To reduce cost by exploiting market rates
*To revise debt condition
*To take advantage of future market conditions.
Thus, the company makes use of currency and interest rate swaps for these reasons.